Behavioral finance strategies come in various shapes and sizes. But what exactly is behavioral finance? Before you dive into the different approaches, it is important to know exactly what you are working with.
In simple terms, behavioral finance is the examination of how psychology influences behavior within financial markets. We have seen this time and time again throughout history. Think about it this way: Even professional investors are affected by personal biases, fear and greed.
To the uninitiated, the concept of human behavior playing a role in a numbers-driven environment may seem to oppose what many investors are led to believe about markets. However, studies confirm these observations are relevant and telling. The CFA Institute agrees:
“By focusing on actual behavior, behavioral researchers have observed that individuals make investment decisions in ways and with outcomes that differ from the approaches and outcomes of traditional finance.”
With that in mind, here are three important behavioral finance strategies to consider.
- Buy Low, Sell High
- Fear of Missing Out (FOMO)
- Loss Aversion
Behavioral Finance Strategies: Buy Low, Sell High
Over the history of investing, perhaps no advice has been dispensed more than “buy low, sell high.” However, investors should not conflate buying low with value investing, because the former can include securities of any factor, not just those that are value names.
The vexing thing about buying low and selling high is that, at least in theory, it sounds really easy. Unfortunately, it makes for a great case study in behavioral finance because few investors execute on this maxim to great success. Goldman Sachs examined the lack of success with this strategy and discovered that human behavior plays a big role.
“Buy low, sell high. Sounds simple. Why can’t more investors do it? Often, the answer is behavioral in nature,” notes Goldman Sachs. “Research shows that investors often buy too high and sell too low, underscoring the role of emotional decision making in investing.”
There are some other mistakes investors make with buying low and selling high. First, many think that buying a low-priced stock is a good deal while buying a stock with a big price tag is a bad idea. Actually, the opposite is often true. Low-priced stocks get there for various reasons, none of which are good.
Second, investors do not account for momentum when it comes to buying low and selling high. Momentum investing is easy to understand. The essential premise is that a security that has been rising or falling for some time can continue doing just that. By not acknowledging momentum, which is a behavioral error, investors can mess up buy low, sell high.
Fear of Missing Out (FOMO)
Fear of missing out, or FOMO, is another cornerstone behavioral finance strategy for multiple reasons, not the least of which is that FOMO is present in our everyday lives. In fact, some academic research classifies FOMO as a phobia. Yikes.
“You see a friend has uploaded pictures of an elaborate dinner at a Hibachi grill. Another has recorded a beach sunset saturated with beautiful pastels. As you scroll through countless stories of your friends doing fun and impressive things, your restlessness continues to build and build,” writes King University. “The emotions are hard to describe, but it feels like a weird combination of exclusion, self-loathing, and envy. It’s a strange and utterly empty feeling.”
In investing, FOMO can be ruinous. Let us use the hypothetical example of Jane and Julie, two friends that both own Tesla (NASDAQ:TSLA) stock. Jane bought the stock in 2019 and has been telling Julie about her good fortune. Growing green with envy, Julie finally relents and buys some shares… in September of this year.
That is not to say Tesla is a bad stock. Price action confirms it is on fire, but FOMO led Julie to outcomes that differ greatly from those Jane are experiencing.
The bottom line here is that most of us do not like being excluded — whether it’s an invitation to a party or missing out on a hot stock. However, there are times when we must find it within ourselves to not acquiesce to FOMO impulses. That is particularly true when money is on the line.
Behavioral Finance Strategies: Loss Aversion
Think of loss aversion along the lines of once bitten, twice shy, meaning investors that have taken losses before are reluctant to pull the trigger again because they’re still thinking about their bad trades.
The woes of loss aversion are compounded when the investor obsesses over the trade he didn’t take and it turns out to be a winner. Fortunately, there are ways for investors to combat loss aversion.
“Loss aversion, like any fear, is useful when it keeps you from taking too much risk, but not when it keeps you from profitable opportunities,” according to Saylor Academy. “Using knowledge to best assess the scope and probability of loss is a way to see the loss in context. Likewise, segregating investments by their goals, risks, liquidity, and time horizons may be useful for, say, encouraging you to save for retirement or some other goal.”
For those craving a simple loss aversion coping mechanism, simply enter “Warren Buffett airline stocks” into the search engine of your choosing. The point is that even the greatest investors make mistakes. It is just part of the game, and they move on to greener pastures.
On the date of publication, Todd Shriber did not have (either directly or indirectly) any positions in any of the securities mentioned in this article.
Todd Shriber has been an InvestorPlace contributor since 2014.